Sacramento 
About 2,000 small-business owners and investors across California are being forced to retroactively pay the state four years of assessments totaling $120 million plus interest, based on a decision by the Franchise Tax Board.

In December, the state agency that administers personal income and corporate taxes ended a nearly 20-year-old tax incentive designed to spur investment in startup companies and small businesses, citing a court ruling. The benefit allowed small-business investors who sold their stock at a gain to exclude half the profits from their income taxes.

Bruce Hansen, who cofounded ID Analytics in San Diego and led the company as chairman and chief executive until its sale to LifeLock for $195 million in 2012, said the biggest heartache was discovering that the state was changing the rules dating back several years. It’s a decision that he says will cost him several hundred thousand dollars.

“I don’t mind paying taxes,” Hansen said. “But California has just gone over the top. This is no way to do business in my mind.”

The agency decision is estimated to affect about 500 small business owners and shareholders for taxes to be paid this year and each of the past four years. The estimate of $120 million plus $8 million in interest only covers the four past years, as taxes this year are not due until April.

The decision was made at the staff level, not by the three members of the Franchise Tax Board — John Chiang, state controller; Jerome E. Horton, chairman of the Board of Equalization; and Ana Matosantos, state finance director.

The central issue is that a legislative policy decision was found unconstitutional, and the Legislature must determine the next course of action, said Jacob Roper, a spokesman for Chiang, chairman of the tax board.

“In the meantime, the controller can sympathize with any taxpayer who faces shifting rules and applications of the law,” Roper said. “Complex and changing tax rules add to a taxpayer’s burden, and this is just one reason the controller thinks a broad tax reform package is overdue.”

The court case at issue was brought against the Franchise Tax Board by Frank Cutler. Cutler sought to take advantage of the tax break but was denied because the law only gave that consideration to small businesses with 80 percent of assets and payroll in California. The 2nd District Court of Appeal held that the statute violated the commerce clause of the U.S. Constitution because it discriminated against out-of-state businesses.

The Franchise Tax Board says it had little choice but to invalidate the exclusion after the August ruling.

“In treating all taxpayers the same — because the statute is now null and void — we are issuing tax assessments for the open years saying you can’t have this exclusion,” spokeswoman Denise Azimi said.

Marty Dakessian, an attorney representing Cutler, questioned why the tax board’s decision to seek back assessments from investors was made at the staff level rather than by tax board members or elected lawmakers. He said the financial incentives to small businesses are critical as the state works its way through the economic recovery.

“These are incentives that encourage the growth of small business and creation of jobs and all the things that people in Sacramento like to talk about,” Dakessian said. “And when you have Franchise Tax Board bureaucrats making decisions based on revenue, without regard for whether this helps or hurts our job-creating climate, that’s a problem.”

“For this decision to not be in the hands of people directly accountable to voters frankly is wrong,” he added. “This is a black eye for California.”

Brian Overstreet, the cofounder and president of AdverseEvents in Healdsburg, blogged about the impact of the decision on his former San Diego-based company.

“This didn’t have an opportunity to have a discussion or go through legislative action,” Overstreet said. “This largely came to light over the holiday break when nobody was around and nobody noticed it until I started screaming from the hilltop.”

Overstreet co-founded an enterprise-focused data company in San Diego in 1999. Last year, he sold Sagient Research Systems in a private transaction he described as positive for everyone involved. He said he had looked forward to the partial state income-tax exclusion. He expected to pay about half the regular rate on the gain from sales of stock (4.5 percent instead of 9 percent).

When the sale closed, Overstreet paid his state and federal estimated taxes with the exclusion, and assumed he was all caught up. He learned last month the program was invalidated.

“I felt angry, confused, upset,” Overstreet said. “Now, I am more resigned to the reality, but I am not going to stop making noise about it.”

Sen. Ted Lieu, D-Torrance, and Assemblyman Jeff Gorell, R-Camarillo, reached out to Overstreet after his post reverberated across the blogosphere.

In an interview, Lieu said he planned to send a letter to the tax board urging the agency to reverse its decision and allow past investors to claim the exclusion.

“I think it’s wrong to retroactively penalize taxpayers who relied in good faith on what the law was five years ago,” Lieu said. “On a going-forward basis, I am fine with them changing the rules. I just believe it is wrong to change the rules retroactively.”

Gorell said he also was prepared to act.

“This falls into the category of egregious activity in terms of holding taxpayers accountable for activities they had done many years in the past,” he said. “This is something we’re going to address.”

Matthew Portnoff, a tax expert in the Los Angeles law office of Manatt, Phelps & Phillips, said there was nothing compelling the tax board to seek back payments with interest.

“This was the most aggressive of the options available to them,” he said.

Azimi, the spokeswoman for the tax board, said the agency’s legal division researched case law, legislative intent and what was done in similar situations in determining that this was the best course of action going forward. She added that there is no provision in the law to waive interest.